Marketplace Scratch Pad

Hands off the shorts

Paddy Hirsch Aug 7, 2009

Felix Salmon has a new rallying cry: three cheers for short-sellers. He argues that short sellers generally protect investors.

No doubt Felix’s column will attract a blizzard of comments from the short-haters. Buit he presents some compelling data to back up his cheerleading, a study by Xiaoxia Lou and Jonathan Karpoff, on whether short sellers identify firms that misrepresent their financial statements, and whether their trading conveys external costs or benefits to other investors.

… evidence indicates that short sellers anticipate the eventual discovery and severity of financial misconduct. Short selling also conveys external benefits to uninformed investors, by helping to uncover financial misconduct and by keeping prices closer to fundamental values when firms provide incorrect financial information.

It’s good to have this kind of perspective in the mix as the SEC considers curbs on short-selling. People have always slung mud at the shorts for one reason or another, but the barracking came to a head last year as the financial crisis gathered pace, and some hedge funds and other investors made a lot of money shorting banks and other institutions.

Enter the SEC, pushed by lawmakers like Barney Frank. The Commission banned certain types of short selling for a period, and since then it’s been reviewing the practise. It looked as though they had some plans ready to go this week, but Bloomberg reported yesterday that the SEC says it needs more time to consider feedback on the issue.

The SEC’s proposals include a measure that resembles the uptick rule, which barred short-selling until a stock brings a price at least one penny higher than the preceding trade. The SEC scrapped the almost 70-year-old provision in July 2007 after agency studies determined it wasn’t relevant in markets dominated by fast-paced trading.
An alternative the SEC is considering would allow short- sales only at prices exceeding the best bid. A bid represents the price investors are willing to pay for a stock.
The agency is also considering multiple circuit breakers, which impose restrictions on bets against individual stocks that have fallen by a certain percentage.

Bloomberg quotes Sean O’Malley, a former attorney in the SEC’s division of trading and markets, now a partner at Goodwin Procter LLP in New York.

“Whatever the SEC comes up with has to actually work. It can’t just be a response to a populist outcry.”

A succinct comment that raises two key issues: whether the Commission will allow itself to be moved by Barney Frank’s fire and brimstone, and whether the SEC can actually come up with anything that works.

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